Chapter 12 Smartbook Reading

True or false: Finding the cost of equity is fairly straightforward.

False; It is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment.

True or false: Projects should always be discounted at the firm's overall cost of capital.

False; Projects' discount rates should reflect their particular level of risk.

True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.

False; Pure plays are companies that specialize only in projects similar to the project your firm is considering.

The formula for calculating the cost of equity capital that is based on the dividend discount model is

RE = D1/P0 + g

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

The discount rate for the firm's projects equals the cost of capital for the firm as a whole when

all projects have the same risk as that of the firm overall

The rate used to discount project cash flows is known as the

cost of capital discount rate required return

In the WACC calculation, D represents the ____ value of the firm's debt

market

The most appropriate weights to use in the WACC are the ______ weights.

market value

The WACC of a firm reflects the ________ and the target capital structure of the firm's existing assets as a whole.

risk

Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?

(P/V) × RP

True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth.

False; The cost of equity is D1/P0 plus the analysts' estimates of growth.

True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend

False; The expected growth rate in dividends must be estimated.

True or false: The primary disadvantage of the dividend growth model approach is its simplicity.

False; The primary advantage of the dividend growth model approach is its simplicity.

The weighted average cost of capital, WACC The firm's WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm. The WACC is calculated as: WACC=(E/V)×RE+(D/V)×RD×(1−TC) where TC is the corporate tax rate, E is the market value of the firm's equity, D is the market value of the firm's debt, and V = E + D. Note that E/V is the percentage of the firm's financing (in market value terms) that is equity and D/V is the percentage that is debt.

False; V=E+D

True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.

False; it is equal to the risk-free rate

Which of the following is true about a firm's cost of debt?

It is easier to estimate than the cost of equity. Yields can be calculated from observable data.

What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

It will accept projects that it should have rejected. It will reject projects that it should have accepted. The firm overall will become riskier.

What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?

RE = D1/P0

What is the equation for finding the cost of preferred stock?

RP = D/P0

True or false: RP = D/P0

True

If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E + D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is

WACC = [E/V] × RE + [D/V] × RD ×(1 − TC)

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes

CANNOT

Which of the following is tax-deductible to the firm?

Coupon interest paid on bonds - interest is tax-deductible

True or false: The discount rate is also known as the expected return.

False

If a firm has multiple projects, each project should be discounted using

a discount rate commensurate with the project's risk

Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by

adding these two components

The following are advantages of the SML approach:

adjusts for risk does not require the company to pay a dividend

Which of the following are components used in the construction of the WACC?

cost of common stock cost of preferred stock cost of debt

The return an investor in a security receives is ______ the cost of the security to the company that issued it.

equal to

If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.

equity

To estimate the dividend yield of a particular stock, we need

forecasts of the dividend growth rate, g the current stock price the last dividend paid, D0

Finding a firm's overall cost of equity is difficult because

it cannot be observed directly

To estimate a firm's equity cost of capital using the SML approach, we need to know the

risk-free rate market risk premium stock's beta

What does WACC stand for?

weighted average cost of capital

For a firm with outstanding debt, the cost of debt will be the ______ on that debt.

yield to maturity